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COURSE CONTENTS: 1. Introduction 2. MATHEMATICAL MODELLING OF UNCERTAINTY IN BUSINESS 3. Case Study No. 3
1. Introduction
Uncertainty is the expression of the incomplete and approximate character of information about factors influencing our future activity. Risk is characterised by the possibility of describing a probability law for the expected results.
1. MATHEMATICAL MODELLING OF UNCERTAINTY IN BUSINESS Measuring uncertainty in business consists of calculating an estimated profitableness rate of the business (project) thus: (1)
where, Rer the estimated profitableness rate pi the probability associated to the variant i; ri the expected profitableness rate of the variant i; i - the variant of the alternative scenario; n the number of the variant.
n R er pi ri i 1
We have a business plan. Each business plan has three variants: - the optimistic variant; - the realistic variant; - the pessimistic variant. In relation number 1, we have two elements: pi and ri. For every variant, it is calculated the probability associated to the variant (the expected probability) noted pi the probability associated to the variant i; Pi, the probability associated to the variant i is: for optimistic variant: pi >0,50; for realistic variant: 0,30 < pi< 0,50; For pessimistic variant: pi < 0,30.
The second element is the expected profitableness rate of the variant i. It is according to the relation:
where, Cu = used capital; Fn = the expected cash flow; r = the expected profitableness rate
1 r
Fn Fn
1
(1 r )
2 2
(1 r )
Fn
3 3
Replacing in the 2nd relation: 1+ r = u and knowing that Fn1 = Fn2 = Fn3 = Fn, the relation becomes:
Cu 1 1 1 Cu 3 Cu 3 2 3 u u2 u 1 u u 2 u 1 0 Fn u u u Fn Fn 3 .
We can determine the value of u, then the value of r results . r=u1 Solving a third degree equation means applying the following graphical methods: the tangent, the chord and the bisectional interval.
After having determined the expected profitableness rate for every variant, we calculate the business estimated profitableness rate for every variant, according to relation 1. The table below results:
Scenario
Associated probability
Cash flow Fn
n R er pi ri i1
pi
0.80
0.60
300,000
0.15
0.20
200,000
r1
-0.15
- 0.03
0.10
100,000
0.25
- 0.02
r2
r3
0.10
0.10
- 0.80
- 0.10
0.10
0.80
ri
Rer = 0.10
CONCLUSION: The narrower the distribution of the probability of the expected profitableness rates of a business (project), the more probable it is that the real profitableness would be closer to the expected profitableness and the lower the business (project) risk would be.
R
C
er
i 1
1
pr 1
i i
1 r
Fn Fn
(1 r )
2 2
(1 r )
Fn
3 3
Cu 1 1 1 Cu 3 Cu 3 2 3 u u2 u 1 u u 2 u 1 0 3 Fn u u u Fn Fn .
pi
Scenario Associated probability pi 0.60 Cash flow Fn 300,000 200,000 100,000 Estimated profitableness rate ri 0.25
Rer
0.80
r1
0.20
-0.15
r2
r3
0.10
0.10
0.25
0.10
- 0.10
0.10
0.80
ri
Rer = 0.10
PROJECT X
Cu=600,000
SCENARIO SCENARIO
PROJECT Y Cu =500,000
Pi
0.60 0.30 0.10
Fln
300,000 200,000 100,000
O R P
ri ? ? ?
Rer ? ? ?
n R er pi ri i1
Pi
0.50 0.30 0.10
Fln
250,000 200,000 50,000
O R P
ri ? ? ?
Rer ? ? ?
n R er pi ri i1